**U.S. SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C.  20549**

 

**FORM 10-Q**

 

| **(Mark One)**                                                                                                                                          |       |                                                                                          |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                    |       |                                                                                          |
| **ý**                                                                                                                                              | ** ** | **Quarterly report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**  |
|                                                                                                                                                    |       |                                                                                          |
| **For the quarterly period ended July 2, 2004 or**                                                                                                      |
|                                                                                                                                                    |       |                                                                                          |
| **o**                                                                                                                                                   | ** ** | **Transition report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934** |
|                                                                                                                                                    |       |                                                                                          |
| **For the period from             to            /** |
|                                                                                                                                                    |       |                                                                                          |
| **Commission file number: 000-30575**                                                                                                                   |

 

**AVOCENT CORPORATION**

(Exact Name of Registrant as Specified in Its Charter)

 
| **Delaware**                                                   | ** ** | **91-2032368**                          |
|----------------------------------------------------------------|------------|-----------------------------------------|
| (State or Other Jurisdiction of Incorporation or Organization) |       | (I.R.S. Employer Identification Number) |
|                                                           |       |                                    |
| **4991 Corporate Drive  Huntsville, Alabama**                  | ** ** | **35805**                               |
| (Address of Principal Executive Offices)                       |       | (Zip Code)                              |

 

**256-430-4000**

(Registrant’s Telephone Number, Including Area Code)

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934, as amended, during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports)and (2) has been subject to such filing requirements for the past 90 days.

 

ý Yes  o No

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of the SecuritiesExchange Act of 1934, as amended).

 

ý Yes  o No

 

As of August 4, 2004, the number ofoutstanding shares of the Registrant’s Common Stock was 49,249,763.

 

 

----

 

**AVOCENT CORPORATION**

**FORM 10-Q**

**July 2, 2004**

 

**INDEX**

 
| Part I     | Financial  Information  |                                                                                                                               |
|------------|-------------------------|------------------------------------------------------------------------------------------------------------------------------------|
|       |                    |                                                                                                                               |
|       | Item 1.                 | Financial Statements (unaudited)                                                                                                   |   |
|       |                    |                                                                                                                               |   |
|       |                    | Condensed Consolidated Statements of  Operations for the Three and Six Months Ended July 2, 2004  and June 27, 2003 |   |
|       |                    | Condensed Consolidated Balance Sheets at  July 2, 2004 and December 31, 2003                                                       |   |
|       |                    | Condensed Consolidated Statements of Cash  Flows for the Six Months Ended July 2, 2004 and June 27, 2003            |   |
|       |                    |                                                                                                                               |   |
|       |                    | Notes to Condensed Consolidated Financial  Statements                                                                              |   |
|       |                    |                                                                                                                               |   |
|       | Item 2.                 | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                        |   |
|       |                    |                                                                                                                               |   |
|       | Item 3.                 | Quantitative and Qualitative Disclosures  about Market Risks                                                                       |   |
|       |                    |                                                                                                                               |   |
|       | Item 4.                 | Controls and Procedures                                                                                                            |   |
|       |                    |                                                                                                                               |   |
| Part II    |  Other Information |                                                                                                                               |
|       |                    |                                                                                                                               |
|       | Item 1.                 | Legal Proceedings                                                                                                                  |   |
|       |                    |                                                                                                                               |   |
|       | Item 2.                 | Changes  in Securities, Use of Proceeds and Issuer Purchases of Equity Securities                                                  |   |
|       |                    |                                                                                                                               |   |
|       | Item 4.                 | Submission of Matters to a Vote of Security  Holders                                                                               |   |
|       |                    |                                                                                                                               |   |
|       | Item 6.                 | Exhibits and Reports on Form 8-K                                                                                                   |   |
|       |                    |                                                                                                                               |   |
| Signatures |                    |                                                                                                                               |

 

2

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**Item 1.****  Financial Statements**

 

**AVOCENT CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

(Unaudited, in thousands, except per share data)

 
| ** **                                                     | ** ** | **For the three months ended** | ** ** | **For the six months ended** | ** ** |
|----------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| ** **                                                     | ** ** | **July 2,  2004**              | ** ** | **June 27,  2003**           | ** ** | **July 2,  2004** | ** ** | **June 27,  2003** | ** ** |
|                                                           |       |                           |       |                         |       |   |   |   |   |
| Net sales                                                      |       | $                              | 87,796     |                         | $          | 70,612 |   | $ | 173,881 |   | $ | 141,774 |   |
| Cost of sales                                                  |       | 37,196                         |       | 29,927                       |       | 73,179 |   | 61,492 |   |
| Gross profit                                                   |       | 50,600                         |       | 40,685                       |       | 100,702 |   | 80,282 |   |
|                                                           |       |                           |       |                         |       |   |   |   |   |
| Research and development expenses                              |       | 11,226                         |       | 7,654                        |       | 20,654 |   | 14,466 |   |
| Acquired in-process research and  development expense          |       | 21,720                         |       | —                       |       | 28,210 |   | — |   |
| Selling, general and administrative expenses                   |       | 22,037                         |       | 18,124                       |       | 42,372 |   | 34,783 |   |
| Amortization of intangible assets                              |       | 6,412                          |       | 6,156                        |       | 11,174 |   | 12,312 |   |
| Total operating expenses                                       |       | 61,395                         |       | 31,934                       |       | 102,410 |   | 61,561 |   |
|                                                           |       |                           |       |                         |       |   |   |   |   |
| Income (loss) from operations                                  |       | (10,795                        | )          | 8,751                        |       | (1,708 | ) | 18,721 |   |
|                                                           |       |                           |       |                         |       |   |   |   |   |
| Net investment income                                          |       | 1,046                          |       | 1,281                        |       | 2,297 |   | 2,507 |   |
| Net realized investment losses                                 |       | (104                           | )          | (123                         | )          | (168 | ) | (210 | ) |
| Other expense, net                                             |       | (98                            | )          | (114                         | )          | (148 | ) | (419 | ) |
|                                                           |       |                           |       |                         |       |   |   |   |   |
| Income (loss) before income taxes                              |       | (9,951                         | )          | 9,795                        |       | 273 |   | 20,599 |   |
| Provision for income taxes                                     |       | 3,441                          |       | 2,450                        |       | 5,122 |   | 5,087 |   |
|                                                           |       |                           |       |                         |       |   |   |   |   |
| Net income (loss)                                              |       | $                              | (13,392    | )                            | $          | 7,345 |   | $ | (4,849 | ) | $ | 15,512 |   |
|                                                           |       |                           |       |                         |       |   |   |   |   |
| Earnings (loss) per share:                                     |       |                           |       |                         |       |   |   |   |   |
| Basic                                                          |       | $                              | (0.27      | )                            | $          | 0.16 |   | $ | (0.10 | ) | $ | 0.34 |   |
| Diluted                                                        |       | $                              | (0.27      | )                            | $          | 0.16 |   | $ | (0.10 | ) | $ | 0.33 |   |
|                                                           |       |                           |       |                         |       |   |   |   |   |
| Weighted average shares used in computing  earnings per share: |       |                           |       |                         |       |   |   |   |   |
| Basic                                                          |       | 49,065                         |       | 45,917                       |       | 48,958 |   | 45,671 |   |
| Diluted                                                        |       | 49,065                         |       | 47,361                       |       | 48,958 |   | 47,026 |   |

 

See notes accompanying these condensed consolidated financialstatements

 

3

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**AVOCENT CORPORATION**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

(Unaudited, in thousands, except per share data)

 
| ** **                                                                                                                                                          | ** ** | **July 2,  2004** | ** ** | **December 31,  2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------------|------------|
|                                                                                                                                                                | * *   | * *          | * *   | * *               | * *   |
| **ASSETS**                                                                                                                                                          |       |              |       |                   |       |
| Current assets:                                                                                                                                                     |       |              |       |                   |       |
| Cash and cash equivalents                                                                                                                                           |       | $                 | 78,294     |                   | $          | 76,492 |   |
| Investments maturing within one year                                                                                                                                |       | 141,176           |       | 146,900                |       |
| Accounts receivable, net                                                                                                                                            |       | 48,688            |       | 45,011                 |       |
| Income taxes receivable                                                                                                                                             |       | 366               |       | 415                    |       |
| Other receivables, net                                                                                                                                              |       | 395               |       | 225                    |       |
| Inventories, net                                                                                                                                                    |       | 22,025            |       | 21,324                 |       |
| Other current assets                                                                                                                                                |       | 3,224             |       | 4,251                  |       |
| Deferred tax assets                                                                                                                                                 |       | 6,644             |       | 4,616                  |       |
| Total current assets                                                                                                                                                |       | 300,812           |       | 299,234                |       |
| Investments                                                                                                                                                         |       | 69,884            |       | 82,884                 |       |
| Property held for lease, net                                                                                                                                        |       | 1,428             |       | 1,526                  |       |
| Property and equipment, net                                                                                                                                         |       | 39,624            |       | 38,473                 |       |
| Goodwill                                                                                                                                                            |       | 262,798           |       | 206,037                |       |
| Other intangible assets, net                                                                                                                                        |       | 43,880            |       | 31,889                 |       |
| Other assets                                                                                                                                                        |       | 950               |       | 720                    |       |
| Total assets                                                                                                                                                        |       | $                 | 719,376    |                   | $          | 660,763 |   |
|                                                                                                                                                                |       |              |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                       |       |              |       |                   |       |
| Current liabilities:                                                                                                                                                |       |              |       |                   |       |
| Accounts payable                                                                                                                                                    |       | $                 | 6,665      |                   | $          | 10,034 |   |
| Accrued wages and commissions                                                                                                                                       |       | 8,355             |       | 9,120                  |       |
| Accrued liabilities                                                                                                                                                 |       | 17,502            |       | 16,866                 |       |
| Income taxes payable                                                                                                                                                |       | 12,274            |       | 6,702                  |       |
| Total current liabilities                                                                                                                                           |       | 44,796            |       | 42,722                 |       |
| Deferred tax liabilities                                                                                                                                            |       | 9,950             |       | 10,884                 |       |
| Total liabilities                                                                                                                                                   |       | 54,746            |       | 53,606                 |       |
|                                                                                                                                                                |       |              |       |                   |       |
| Commitments and contingencies                                                                                                                                       |       |              |       |                   |       |
|                                                                                                                                                                |       |              |       |                   |       |
| Stockholders’ equity:                                                                                                                                          |       |              |       |                   |       |
| Preferred stock, $0.001 par value; 5,000  shares authorized, no shares issued and outstanding as of July 2, 2004 and  December 31, 2003, respectively               |       | —            |       | —                 |       |
| Common stock, $0.001 par value; 200,000  shares authorized, 49,212 and 47,350 shares issued and outstanding as of July  2, 2004 and December 31, 2003, respectively |       | 49                |       | 47                     |       |
| Additional paid-in capital                                                                                                                                          |       | 1,048,417         |       | 982,218                |       |
| Accumulated other comprehensive income  (loss)                                                                                                                      |       | (166              | )          | 227                    |       |
| Deferred compensation                                                                                                                                               |       | (4,929            | )          | (1,443                 | )          |
| Accumulated deficit                                                                                                                                                 |       | (378,741          | )          | (373,892               | )          |
| Total stockholders’ equity                                                                                                                                     |       | 664,630           |       | 607,157                |       |
| Total liabilities and stockholders’ equity                                                                                                                     |       | $                 | 719,376    |                   | $          | 660,763 |   |

 

See notes accompanying these condensed consolidated financialstatements.

 

4

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**AVOCENT CORPORATION**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

(Unaudited, in thousands)

 
| ** **                                                                                | ** ** | **For the six months ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                | ** ** | **July 2,  2004**            | ** ** | **June 27,  2003** | ** ** |
|                                                                                      | * *   | * *                     | * *   | * * | * * |
| Cash flows from operating activities:                                                     | * *   | * *                     | * *   | * * | * * |
| Net income (loss):                                                                        |       | $                            | (4,849     | ) | $ | 15,512 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities: |       |                         |       |   |   |
| Depreciation                                                                              |       | 2,993                        |       | 2,350 |   |
| Amortization of intangible assets                                                         |       | 11,174                       |       | 12,312 |   |
| Stock-based compensation                                                                  |       | 2,864                        |       | 3,225 |   |
| Acquired in-process research and  development expenses                                    |       | 28,210                       |       | — |   |
| Amortization of premiums on investments                                                   |       | 2,101                        |       | 1,645 |   |
| Net loss on sales of investments                                                          |       | 168                          |       | 210 |   |
| Income tax benefit from exercise of stock  options                                        |       | 2,256                        |       | 4,787 |   |
| Changes in operating assets and liabilities  (net of effects of acquisitions):            |       |                         |       |   |   |
| Accounts receivable, net                                                                  |       | (3,465                       | )          | (2,242 | ) |
| Other receivables, net                                                                    |       | (17                          | )          | 608 |   |
| Inventories, net                                                                          |       | (555                         | )          | 3,895 |   |
| Other assets                                                                              |       | 1,636                        |       | 123 |   |
| Accounts payable                                                                          |       | (3,840                       | )          | 1,519 |   |
| Accrued wages and commissions                                                             |       | (1,659                       | )          | (1,237 | ) |
| Accrued liabilities                                                                       |       | (60                          | )          | (49 | ) |
| Income taxes, current and deferred                                                        |       | (4,415                       | )          | (4,002 | ) |
| Net cash provided by operating activities                                                 |       | 32,542                       |       | 38,656 |   |
|                                                                                      |       |                         |       |   |   |
| Cash flows from investing activities:                                                     |       |                         |       |   |   |
| Purchase of OSA, net of cash received (1)                                                 |       | (47,179                      | )          | — |   |
| Purchase of Crystal Link, net of cash  received (1)                                       |       | (3,311                       | )          | — |   |
| Purchases of property and equipment                                                       |       | (3,690                       | )          | (10,393 | ) |
| Purchases of investments                                                                  |       | (108,898                     | )          | (116,235 | ) |
| Maturities and proceeds from sales of  investments                                        |       | 124,836                      |       | 70,687 |   |
| Net cash used in investing activities                                                     |       | (38,242                      | )          | (55,941 | ) |
|                                                                                      |       |                         |       |   |   |
| Cash flows from financing activities:                                                     |       |                         |       |   |   |
| Repayment of debt assumed at the  acquisition of Crystal Link                             |       | (1,798                       | )          | — |   |
| Proceeds from employee stock option  exercises                                            |       | 7,803                        |       | 13,851 |   |
| Proceeds from employee stock purchase plan                                                |       | 1,371                        |       | 657 |   |
| Net cash provided by financing activities                                                 |       | 7,376                        |       | 14,508 |   |
|                                                                                      |       |                         |       |   |   |
| Effect of exchange rate changes on cash and  cash equivalents                             |       | 126                          |       | 120 |   |
|                                                                                      |       |                         |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                     |       | 1,802                        |       | (2,657 | ) |
| Cash and cash equivalents at beginning of  period                                         |       | 76,492                       |       | 61,699 |   |
| Cash and cash equivalents at end of period                                                |       | $                            | 78,294     |   | $ | 59,042 |   |

 

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(1)          Supplementaldisclosure – In addition to the cash paid at the respective closings, we issued106 shares of our common stock valued at $3,500 to Crystal Link shareholdersand 1,229 shares of our common stock valued at $45,831 to OSA shareholders. Theissuance of common stock was recorded as non-cash consideration for theacquisition.

 

See notes accompanying these condensed consolidated financialstatements.

 

5

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**AVOCENT CORPORATION**

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

(Unaudited, in thousands)

 

Note 1.          Basis of Presentation

 

The accompanyingunaudited condensed consolidated financial statements have been prepared inconformity with generally accepted accounting principles and reflect alladjustments consisting of normal recurring adjustments which, in the opinion ofmanagement, are necessary for a fair presentation of the results for the threeand six months ended July 2, 2004 and June 27, 2003.  The results of operations for these periodsare not necessarily indicative of the results expected for the full fiscal yearor for any future periods.  The preparationof financial statements in conformity with generally accepted accounting principlesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.  Actual results could differ from thoseestimates and assumptions.

 

The accompanyingunaudited condensed consolidated financial statements should be read inconjunction with the audited consolidated financial statements and the relatednotes contained in our Annual Report on Form 10-K for the year ended December31, 2003, which is on file with the Securities and Exchange Commission. Thebalance sheet presented in the accompanying financial statements for December31, 2003, was derived from the audited financial statements filed in our 10-Kfor the period ended December 31, 2003.

 

We report ourannual results based on years ending December 31.  We report our quarterly results for the firstthree interim periods based on 13 week periods ending on Fridays and for thefourth interim period ending on December 31.

 

Our financialstatements are consolidated and include the accounts of Avocent Corporation andour wholly owned subsidiaries. Significant inter-company transactions and balances have been eliminatedin consolidation.

 

Note 2.          Inventories

 

Inventoriesconsisted of the following at:

 
| ** **       | ** ** | **July 2,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------|------------|-------------------|------------|------------------------|------------|
|             |       |              |       |                   |       |
| Raw materials    |       | $                 | 4,788      |                   | $          | 4,155 |   |
| Work-in-process  |       | 418               |       | 659                    |       |
| Finished goods   |       | 16,819            |       | 16,510                 |       |
| Inventories, net |       | $                 | 22,025     |                   | $          | 21,324 |   |

 

Inventories above have been reduced byreserves for excess and obsolete inventories of $3,620 and $4,020 as of July 2,2004 and December 31, 2003, respectively.

 

Note 3.          Stock Options andDeferred Compensation

 

Deferredcompensation — We recorded $41,165 of deferred compensation related to Cybexemployee stock options at the time of the merger of Apex and Cybex on July 1,2000, $2,752 of deferred compensation related to the Equinox employee stockoptions at the time of the acquisition on January 3, 2001 and $6,350 ofdeferred compensation related to the OSA employee stock options at the time ofthe acquisition on April 6, 2004.  Thedeferred compensation is being amortized over the vesting period of the optionsfor which it was recorded. Amortization of deferred compensation totaled $2,143for the three months ended July 2, 2004 and $1,610 for the three months endedand June 27, 2003.  Amortization ofdeferred compensation totaled $2,864 for the six months ended July 2, 2004 and$3,225 for the six months ended June 27, 2003.

 

Stock option exercises — Shares of our commonstock issued as a result of option exercises totaled 436 shares during the sixmonths ended July 2, 2004 and 973 shares during the six months ended June 27,2003.  Total proceeds received from theseoption exercises were $7,803 for the six months ended July 2, 2004 and $13,851for the six months ended June 27, 2003. Common stock issued under our Employee StockPurchase Plan totaled 89 shares during the six months ended July 2, 2004 and 51shares during the six months ended June 27, 2003.  Total proceeds received from the sharesissued under the ESPP were $1,371 for the six months ended July 2, 2004 and $657for the six months ended June 27, 2003. 

 

6

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Note 4.          Accumulated OtherComprehensive Income

 

We record, net of tax, unrealizedgains and losses on our foreign currency translation adjustments and unrealized holding gains or losses on our available-for-salesecurities as accumulated other comprehensive income (loss), which is includedas a separate component of stockholders’ equity.  Comprehensive loss for the first six monthsof 2004 of $5,242 consists of $4,849 of net loss, $519 of unrealized losses oninvestments (net of deferred income taxes) and $126 of foreign currencytranslation gain (net of deferred income taxes).  Comprehensive income for the firstsix months of 2003 of $16,619 consists of $15,512 of net income, $987 ofunrealized gains on investments (net of deferred income taxes) and $120 offoreign currency translation gain (net of deferred income taxes).  As of July2, 2004 and December 31, 2003, total accumulated other comprehensive income(loss) was ($166) and $227, respectively.

 

Note 5.          Earnings (loss) perShare

 
| ** **                                                          | ** ** | **Income  (Numerator)** | ** ** | **Shares  (Denominator)** | ** ** | **Per-Share  Amount** | ** ** |
|---------------------------------------------------------------------|------------|-------------------------|------------|---------------------------|------------|-----------------------|------------|
|                                                                |       |                    |       |                      |       |                  |       |
| **For the  three months ended July 2, 2004**                        |       |                    |       |                      |       |                  |       |
| **Basic EPS**                                                       |       |                    |       |                      |       |                  |       |
| Net loss available to common stockholders                           |       | $                       | (13,392    | )                         | 49,065     |                  | $          | (0.27 | ) |
| **Effect of Dilutive Securities**                                   |       |                    |       |                      |       |                  |       |
| Stock options                                                       |       | —                  |       | —                    |       | —                |       |
| **Diluted EPS**                                                     |       |                    |       |                      |       |                  |       |
| Net loss available to common stockholders and assumed conversions   |       | $                       | (13,392    | )                         | 49,065     |                  | $          | (0.27 | ) |
|                                                                |       |                    |       |                      |       |                  |       |
| **For the three months ended June 27, 2003**                        |       |                    |       |                      |       |                  |       |
| **Basic EPS**                                                       |       |                    |       |                      |       |                  |       |
| Net income available to common stockholders                         |       | $                       | 7,345      |                      | 45,917     |                  | $          | 0.16 |   |
| **Effect of Dilutive Securities**                                   |       |                    |       |                      |       |                  |       |
| Stock options                                                       |       | —                  |       | 1,444                     |       | —                |       |
| **Diluted EPS**                                                     |       |                    |       |                      |       |                  |       |
| Net income available to common stockholders and assumed conversions |       | $                       | 7,345      |                      | 47,361     |                  | $          | 0.16 |   |
|                                                                |       |                    |       |                      |       |                  |       |
| **For the six months ended July 2, 2004**                           |       |                    |       |                      |       |                  |       |
| **Basic EPS**                                                       |       |                    |       |                      |       |                  |       |
| Net loss available to common stockholders                           |       | $                       | (4,849     | )                         | 48,958     |                  | $          | (0.10 | ) |
| **Effect of Dilutive Securities**                                   |       |                    |       |                      |       |                  |       |
| Stock options                                                       |       | —                  |       | —                    |       | —                |       |
| **Diluted EPS**                                                     |       |                    |       |                      |       |                  |       |
| Net loss available to common stockholders and assumed conversions   |       | $                       | (4,849     | )                         | 48,958     |                  | $          | (0.10 | ) |
|                                                                |       |                    |       |                      |       |                  |       |
| **For the six months ended June 27, 2003**                          |       |                    |       |                      |       |                  |       |
| **Basic EPS**                                                       |       |                    |       |                      |       |                  |       |
| Net income available to common stockholders                         |       | $                       | 15,512     |                      | 45,671     |                  | $          | 0.34 |   |
| **Effect of Dilutive Securities**                                   |       |                    |       |                      |       |                  |       |
| Stock options                                                       |       | —                  |       | 1,355                     |       | —                |       |
| **Diluted EPS**                                                     |       |                    |       |                      |       |                  |       |
| Net income available to common stockholders and assumed conversions |       | $                       | 15,512     |                      | 47,026     |                  | $          | 0.33 |   |

 

Anti-dilutiveoptions to purchase common stock outstanding were excluded from thecalculations above.  For the three andsix months ended July 2, 2004, options to purchase 7,907 shares of common stockwere outstanding but were not included in the computation of diluted net lossper share as inclusion of these options would have been anti-dilutive.  Anti-dilutive options totaled 1,930 and 2,450for the three and six months ended June 27, 2003, respectively.

 

7

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Note 6.          Sales by GeographicRegion

 

We have evaluated, and will periodically re-evaluate, our business inlight of the segment reporting requirements prescribed by SFAS No. 131, *Disclosures about Segments of an Enterprise and Related Information.*  We have determined that we should report ouroperations as a single operating segment. However, we supplementally report sales by geographic region, as well asby customer type.  Following is apresentation of sales by geographic region and by customer type for the threeand six months ended July 2, 2004 and June 27, 2003:

 
| ** **        | ** ** | **For the Three Months  Ended** | ** ** | **For the Six Months  Ended** | ** ** |
|-------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **        | ** ** | **July 2,  2004**               | ** ** | **June 27,  2003**            | ** ** | **July 2,  2004** | ** ** | **June 27,  2003** | ** ** |
|              |       |                            |       |                          |       |   |   |   |   |
| Net sales:        |       |                            |       |                          |       |   |   |   |   |
| United States     |       | $                               | 52,860     |                          | $          | 44,170 |   | $ | 104,050 |   | $ | 86,491 |   |
| Rest of the World |       | 34,936                          |       | 26,442                        |       | 69,831 |   | 55,283 |   |
|              |       | $                               | 87,796     |                          | $          | 70,612 |   | $ | 173,881 |   | $ | 141,774 |   |

 
| ** ** | ** ** | **For the Three Months  Ended** | ** ** | **For the Six Months  Ended** | ** ** |
|------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** ** | ** ** | **July 2,  2004**               | ** ** | **June 27,  2003**            | ** ** | **July 2,  2004** | ** ** | **June 27,  2003** | ** ** |
|       |       |                            |       |                          |       |   |   |   |   |
| Net sales: |       |                            |       |                          |       |   |   |   |   |
| Branded    |       | $                               | 49,990     |                          | $          | 38,883 |   | $ | 100,699 |   | $ | 76,872 |   |
| OEM        |       | 37,806                          |       | 31,729                        |       | 73,182 |   | 64,902 |   |
|       |       | $                               | 87,796     |                          | $          | 70,612 |   | $ | 173,881 |   | $ | 141,774 |   |

 

We sell our products internationally to customers in several countries.Sales to customers in the Netherlands, including the European distributionfacility for one of our OEM customers, accounted for 11% of sales in the firstsix months of 2004.  Sales to customersin the United Kingdom, including the European distribution facility for one ofour OEM customers, accounted for 13% of sales in the first six months of2003.  No other country accounted formore than 10% of sales in the first six months of either 2004 or 2003.

 

**As ofJuly 2, 2004, long-lived assets totaled $347,730, which includes $334,804 heldin the U.S. and $12,926 held outside of the U.S.  As of December 31, 2003, long-lived assetstotaled $277,925, which includes $267,048 held in the U.S. and $10,877 heldoutside of the U.S.**

 

Note 7.          Forward Contracts

 

**We useforward contracts to reduce our foreign currency exposure related to the netcash flows from our international operations. The majority ofthese contracts are short-term contracts (three months or less) and aremarked-to-market each quarter and included in trade payables, with theoffsetting gain or loss included in other income (expense) in the accompanyingconsolidated statements of operations. As of July 2, 2004 and December 31, 2003, we had no open forwardcontracts.**

 

Note 8.          Acquisitions of OSATechnologies, Inc. and Crystal Link Technologies

 

**OSA Technologies, Inc.**

 

On April 6, 2004, we acquired the outstandingstock of OSA Technologies, Inc. (OSA). OSA is headquartered in San Jose, California and has additional officesin Shanghai, China and Taipei, Taiwan. OSA has developed embedded manageabilityfirmware and software using Intelligent Platform Management Interface (IPMI)solutions. The acquisition of OSA will enhance our position in the embeddedmanagement market and OSA’s embedded management solutions for the IPMI marketcomplements our core KVM business and builds upon prior acquisitions.  The results of OSA’s operations have beenincluded in the consolidated financial statements since the date ofacquisition.

 

8

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The acquisition was recorded under thepurchase method of accounting, and the purchase price was allocated based onthe fair value of the assets acquired and liabilities assumed. In accordancewith generally accepted accounting principles, purchased research anddevelopment costs allocated to patent-pending technology were capitalized andwill be amortized over the respective estimated useful lives.  The remaining amounts of purchased researchand development were expensed upon the closing of the transaction.  The goodwill recorded as result of theacquisition will not be amortized but will be included in our annual review ofgoodwill for impairment. Additionally, the goodwill recorded is not taxdeductible.  The excess of the fair valueover the intrinsic value of the unvested OSA options and the fair value of thevested OSA options at the date of consummation have been included in thepurchase consideration. A summary of the total purchase consideration,excluding cash received, is as follows:

 
| Cash paid for outstanding shares                     |   | $      | 51,685  |   |
|------------------------------------------------------|--------|--------|---------|--------|
| Value of common stock issued for  outstanding shares |   | 45,831 |    |
| Value of stock options assumed                       |   | 2,526  |    |
| Acquisition costs                                    |   | 1,113  |    |
|                                                 |   |   |    |
| Total purchase consideration                         |   | $      | 101,155 |   |

 

We funded the acquisition through availablecash and by the issuance of 1,229 shares of Avocent common stock.  The common stock, valued at approximately$45,831, was recorded as non-cash consideration for the acquisition of OSA. Onthe closing of the OSA transaction, we acquired $5,618 in cash held by OSA.

 

Thepurchase consideration was allocated, on a preliminary basis, to the estimatedfair values of the assets acquired and liabilities assumed, as follows:

 
| ** **                          | ** ** | **Purchase  Price  Allocation** | ** ** | **Amortization  Period** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|--------------------------|------------|
| Tangible assets                     |       | $                               | 11,718     |                     | Various    |   |
| In-process research and development |       | 21,720                          |       | —                   |       |
| Developed technology                |       | 12,380                          |       | 3 years                  |       |
| Customer base                       |       | 4,260                           |       | 5 years                  |       |
| Trademarks                          |       | 3,240                           |       | 3 years                  |       |
| Non-compete agreements              |       | 960                             |       | 3 years                  |       |
| Goodwill                            |       | 57,131                          |       | —                   |       |
| Deferred taxes                      |       | (8,544                          | )          | Various                  |       |
| Assumed liabilities                 |       | (1,710                          | )          | —                   |       |
|                                |       |                            |       |                     |       |
|                                |       | $                               | 101,155    |                     |       |   |

 

Additionally, we recorded $6,350 of deferredcompensation related to the unvested OSA employee stock options at the time ofthe acquisition on April 6, 2004.  Thedeferred compensation is being amortized straight-line over the vesting periodof the options for which it was recorded.

 

Thefair value of all of the in-process research and development (“IPR&D”)received in the acquisition was determined using a form of the discounted cashflow method known as the multi-period excess earnings method.  These amounts were deemed to be forparticular research and development projects that have no alternative futureuses and were therefore expensed rather than capitalized at the time ofpurchase.

 

OSA’sin-process research and development activities consisted of an upgrade of itsFirmware Suite to Version 2.0 and an embedded server management product.  The status of these projects varied, however,it is anticipated that the products will be completed during 2005 and2006.   These projects were still inprocess at the end of the second quarter 2004.

 

9

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Thenew generations of products under development are projected to sell throughsales channels and to customers that are substantially the same as current andhistorical sales channels and customers. Pricing and margins will not differsignificantly from historical pricing and margins.  Revenue for the projects under developmentwas projected through 2012, with 50% of OSA’s forecasted revenue in 2006 comingfrom projects currently in development.  Net income attributable to IPR&D was calculated by applying OSA’sprojected gross, operating and net profit margins to IPR&D revenue, whileconsidering Avocent’s historical results and industry prospects.

 

Revenuegrowth related to the in-process research and development is embodied inproducts to be launched during 2005. These products have estimated economiclives ranging from approximately six to nine years. The product life cycle ischaracterized by a gradual 2 to 3 year ramp up period, followed by a 1 to 2year plateau, followed by a 3 to 4 year decline period. Operating margins areprojected to be well above historical Avocent margins as these products areprimarily software in nature. The discount rate used to value IPR&D was24%.

 

**Crystal Link Technologies**

 

**OnJanuary 6, 2004, we acquired the outstanding common shares of Crystal LinkTechnologies (“Crystal Link”) for approximately $6,652 in cash and commonstock, plus the assumption of liabilities and payment of certain acquisitioncosts.  The purchase agreement calls foradditional potential earn-out payments of up to $5,000 based on futuretechnical enhancements and achievement of certain sales goals.  The results of Crystal Link’s operations havebeen included in the consolidated financial statements since the date ofacquisition.  Crystal Link, headquarteredin Escondido, CA, has developed wireless technology for KVM switching andextension products, which is incorporated into our LongView Wireless product.**

 

The acquisition was recorded under thepurchase method of accounting, and the purchase price was allocated based onthe fair value of the assets acquired and liabilities assumed. In accordancewith generally accepted accounting principles, purchased research anddevelopment costs allocated to patent-pending technology were capitalized andwill be amortized over the respective estimated useful lives.  The remaining amounts of purchased researchand development were expensed upon the closing of the transaction.  The valuation resulted in an excess ofacquired nets assets over cost, or negative goodwill in the amount of $143. Asprescribed under FAS 141, *Business Combinations*,the negative goodwill was recorded as a contingent liability due to thepotential future earn-outs.  Goodwillwill likely be recorded if the additional earn-outs mentioned previously areachieved.  If the earn-outs are notachieved, the negative goodwill will be allocated across all acquired assets,including acquired research and development expense.  In the event goodwill is recorded due to theearn-out payments, then goodwill will not be amortized but will be included inour annual review of goodwill for impairment. A summary of the total purchase consideration is as follows:

 
| Cash paid  for outstanding shares                    |   | $      | 3,152  |   |
|------------------------------------------------------|--------|--------|--------|--------|
| Value of common stock issued for  outstanding shares |   | 3,500  |   |
| Acquisition costs                                    |   | 163    |   |
|                                                 |   |   |   |
| Total purchase consideration                         |   | $      | 6,815  |   |

 

Thepurchase consideration was allocated, on a preliminary basis, to the estimatedfair values of the assets acquired and liabilities assumed, as follows:

 
| ** **                          | ** ** | **Purchase  Price  Allocation** | ** ** | **Amortization  Period** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|--------------------------|------------|
| Tangible assets                     |       | $                               | 295        |                     | Various    |   |
| In-process research and development |       | 6,490                           |       | —                   |       |
| Developed technology                |       | 520                             |       | 3 years                  |       |
| Non-compete agreements              |       | 500                             |       | 3 years                  |       |
| International marketing rights      |       | 1,250                           |       | 3 years                  |       |
| Contingent consideration liability  |       | (143                            | )          | —                   |       |
| Assumed liabilities                 |       | (2,097                          | )          | —                   |       |
|                                |       |                            |       |                     |       |
|                                |       | $                               | 6,815      |                     |       |   |

 

10

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The acquisition was funded through availablecash and by the issuance of 107 shares of Avocent common stock.  The common stock, valued at approximately$3,500, was recorded as non-cash consideration for the acquisition of CrystalLink. On the closing of the Crystal Link transaction, we acquired $4 in cashheld by Crystal Link.

 

Thefair value of all of the in-process research and development (“IPR&D”)received in the acquisition was determined using a form of the discounted cashflow method known as the multi-period excess earnings method.  These amounts were deemed to be forparticular research and development projects that have no alternative futureuses and were therefore expensed rather than capitalized at the time ofpurchase.

 

CrystalLink’s in-process research and development activities consisted of a secondgeneration of the KVM wireless extender with significant enhancements to thedeveloped KVM wireless extender product and the development of a wireless KVMswitch and an embedded KVM switch solution. The status of these projects varied from 10% complete to 60%complete.  It is anticipated that each ofthese products will be completed during 2004, however,the projects were still in process at the end of the first quarter 2004.

 

Thenew generations of products under development are projected to sell throughsales channels and to customers that are substantially the same as current andhistorical sales channels and customers. Pricing and margins will not differsignificantly from historical pricing and margins.  Revenue for the projects under developmentwas projected through 2013, with 100% of Crystal Link’s forecasted revenue in2005 coming from projects currently in development.   Net income attributable to IPR&D wascalculated by applying Crystal Link’s projected gross, operating and net profitmargins to IPR&D revenue, while considering Avocent’s historical resultsand industry prospects.

 

Revenuegrowth related to the in-process research and development is embodied inproducts to be launched in late 2004. These products have estimated economiclives ranging from approximately seven to ten years. The product life cycle ischaracterized by a gradual 3 to 4 year ramp up period, followed by a 1 to 2year plateau, followed by a 3 to 4 year decline period. Operating margins areprojected to be below overall historical Avocent margins in the early years,but will improve for these products over their lives as the products mature, ascosts are designed out of the products, and as sales volumes increase. Thediscount rate used to value IPR&D was 20%.

 

**Pro FormaFinancial Information -**The following unaudited pro formasummary combines the results of operations of Avocent, Soronti (acquired inNovember of 2003), Crystal Link and OSA as if the acquisitions had occurred atthe beginning of each period presented. Certain adjustments have been made to reflect the impact of the purchasetransactions. These pro forma results have been prepared for comparativepurposes only and do not purport to be indicative of what would have occurredhad the acquisitions been made at the beginning of 2003, or of results whichmay occur in the future.

 

 

| ** **               | ** ** | **Three  Months Ended,** | ** ** | **Six Months Ended,** | ** ** |
|--------------------------|------------|--------------------------|------------|-----------------------|------------|
| ** **               | ** ** | **July 2, 2004**         | ** ** | **June 27, 2003**     | ** ** | **July 2, 2004** | ** ** | **June 27, 2003** | ** ** |
| ** **               | ** ** | ** **               | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net sales                |       | $                        | 87,796     |                  | $          | 70,752 |   | $ | 174,466 |   | $ | 142,257 |   |
| Net income               |       | $                        | 12,157     |                  | $          | 3,043 |   | $ | 16,792 |   | $ | 7,114 |   |
| Income per basic share   |       | $                        | 0.25       |                  | $          | 0.07 |   | $ | 0.34 |   | $ | 0.15 |   |
| Income per diluted share |       | $                        | 0.24       |                  | $          | 0.06 |   | $ | 0.33 |   | $ | 0.16 |   |
|                     |       |                     |       |                  |       |   |   |   |   |   |   |   |   |

 

**The aboveamounts exclude acquired in-process research and development expense of $21,720related to the OSA acquisition, $3,829 (net of a $2,661 tax benefit) related tothe Crystal Link acquisition and $3,940 related to the Soronti acquisition.**

 

11

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Note 9.          Goodwill and OtherIntangible Assets

 

**Acquiredother intangible assets subject to amortization were as follows:**

 
| ** **                      | ** ** | **July 2, 2004**             | ** ** | **December 31, 2003**         | ** ** |
|---------------------------------|------------|------------------------------|------------|-------------------------------|------------|
| ** **                      | ** ** | **Gross  Carrying  Amounts** | ** ** | **Accumulated  Amortization** | ** ** | **Gross  Carrying  Amounts** | ** ** | **Accumulated  Amortization** | ** ** |
| Developed technology            |       | $                            | 79,140     |                          | $          | 53,495 |   | $ | 66,240 |   | $ | 45,824 |   |
| Patents and trademarks          |       | 21,187                       |       | 11,795                        |       | 17,657 |   | 9,566 |   |
| Customer base and certification |       | 5,873                        |       | 1,199                         |       | 1,613 |   | 717 |   |
| Non-compete agreements          |       | 4,733                        |       | 2,163                         |       | 3,273 |   | 1,455 |   |
| Other                           |       | 1,814                        |       | 215                           |       | 768 |   | 100 |   |
|                            |       | $                            | 112,747    |                          | $          | 68,867 |   | $ | 89,551 |   | $ | 57,662 |   |

 

**Forthe three months ended July 2, 2004 and June 27, 2003, amortization expense forother intangible assets was $6,412 and $6,156, respectively. For the six monthsended July 2, 2004 and June 27, 2003, amortization expense for other intangibleassets was $11,174 and $12,312, respectively. The approximate estimated annualamortization for other intangibles is as follows:**

 

| **Years  ending December 31:** | ** ** | ** ** | ** ** |
|--------------------------------|------------|------------|------------|
| 2004                           |       | $          | 23,440     |   |
| 2005                           |       | $          | 18,240     |   |
| 2006                           |       | $          | 9,740      |   |
| 2007                           |       | $          | 2,520      |   |
| 2008                           |       | $          | 850        |   |
| Thereafter                     |       | $          | 210        |   |

 

**Inaccordance with Statement of Financial Accounting Standards No. 142, *Goodwill and Other Intangible Assets*, we will test goodwillat least annually for impairment.  Unlessconditions warrant earlier review, we perform the annual impairment test in thefourth quarter of each year.**

 

**Werecorded approximately $57,131 of goodwill as result of the OSA acquisition inthe second quarter of 2004 (see Note 8 for a discussion of goodwill and for adiscussion of contingent consideration).**

 

Note 10.    Product Warranties

 

The activity within the liability forwarranty returns for the six months ended July 2, 2004:

 

| ** **                                                | ** ** | **2004** | ** ** |
|-----------------------------------------------------------|------------|----------|------------|
|                                                      |       |     |       |
| Balance, December 31, 2004                                |       | $        | 2,652      |   |
|                                                      |       |     |       |
| Accruals for product warranties issued  during the period |       | 223      |       |
| Settlements made during the period                        |       | (223     | )          |
| Other                                                     |       | (46      | )          |
|                                                      |       |     |       |
| Balance, July 2, 2004                                     |       | $        | 2,606      |   |

 

Deferred revenue related to our extended warranty program was $1,280for the six months ended July 2, 2004. We recorded earned revenue from the amortization of deferred revenuerelated to extended warranties of $249 for the six months ended July 2,2004.  In addition, we recorded newextended warranties of $483 during the six months ended July 2, 2004.

 

12

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Note 11.    Income Taxes

 

The provision for income taxes was approximately $5,122 for the sixmonths ended July 2, 2004, compared to $5,087 for the six months ended June 27,2003.  The increase in the effective tax rate is primarily attributable tothe impact of $21,720 of acquired in-process research and development expense,which is not deductible for tax purposes, and $1,422 of additional deferredcompensation expense (related to assumed incentive stock options which have notax benefit to the company)  recorded during the second quarter as aresult of the acquisition of OSA.   This amount was offset by the taximpact of a higher mix of pre-tax income contributed by our Shannon operationsthat is taxed at a lower rate.

 

Note 12.    Patent Dispute

 

In May 2001, wefiled a complaint for patent infringement in the United States District Courtfor the Southern District of New York against RaritanComputer Inc. The Raritan complaint sought injunctive relief, damages,attorneys’ fees and costs under three of our patents.  After a seven day bench trial in New York inJanuary of 2002, U.S. District Judge Milton Pollack found that therewas no infringement of these patents by Raritan and ordered that judgment beentered in favor of Raritan.

 

In April 2003, the United States Court of Appeals for the FederalCircuit issued its ruling on our appeal in this patent litigation.  The Court of Appeals ruled in our favor byvacating the non-infringement decision of the District Court for the SouthernDistrict of New York and remanding the case for further proceedings consistentwith the Court of Appeals’ opinion.

 

In September 2003, Raritan petitioned theUnited States Supreme Court for a Writ of Certiorari to review the Court ofAppeals decision.  The Supreme Courtdeclined to review Raritan’s petition in December 2003, and the case is nowback before the United States District Court for the Southern District of NewYork.

 

In October 2003, we filed a complaint forpatent infringement in the United States District Court for the NorthernDistrict of Alabama against ClearCube Technology, Inc.  The ClearCube complaint seeks injunctiverelief, damages, attorneys’ fees, and costs under two of our patents. ClearCubefiled counterclaims alleging non-infringement, unenforceability, invalidity,and misuse of the Avocent patents.

 

Note 13.    Stock Based Compensation

 

**Weapply Accounting Principles Board Opinion No. 25, *Accountingfor Stock Issued to Employees*, and related Interpretations inaccounting for our stock plans. Had compensation cost for our stock-basedcompensation plans been determined based on the fair value at the grant datesfor awards under those plans consistent with the method prescribed in SFAS No. 123,*Accounting for Stock-Based Compensation*,our net income and earnings per share would have been reduced to the pro formaamounts indicated below.**

 

13

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| ** **                                                                                                                              | ** ** | **Three Months ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                                              | ** ** | **July 2, 2004**       | ** ** | **June 27, 2003**    | ** ** | **July 2, 2004** | ** ** | **June 27, 2003** | ** ** |
| Net income (loss) — as reported                                                                                                    |       | $                      | (13,392    | )                    | $          | 7,345 |   | $ | (4,849 | ) | $ | 15,512 |   |
| Add: Stock-based employee compensation  expense included in reported net income, net of related tax effects                             |       | 2,098                  |       | 1,496                |       | 2,774 |   | 2,997 |   |
| Deduct: Total stock based employee  compensation expense determined under fair value method for all awards, net  of related tax effects |       | 10,873                 |       | 8,318                |       | 18,041 |   | 15,857 |   |
| Net income (loss) — pro forma                                                                                                      |       | $                      | (22,167    | )                    | $          | 523 |   | $ | (20,115 | ) | $ | 2,652 |   |
|                                                                                                                                    |       |                   |       |                 |       |   |   |   |   |
| Basic earnings (loss) per share — as  reported                                                                                     |       | $                      | (0.27      | )                    | $          | 0.16 |   | $ | (0.10 | ) | $ | 0.34 |   |
| Basic earnings (loss) per share — pro forma                                                                                        |       | $                      | (0.45      | )                    | $          | 0.01 |   | $ | (0.41 | ) | $ | 0.06 |   |
| Diluted earnings (loss) per share — as  reported                                                                                   |       | $                      | (0.27      | )                    | $          | 0.16 |   | $ | (0.10 | ) | $ | 0.33 |   |
| Diluted earnings (loss) per share — pro  forma                                                                                     |       | $                      | (0.45      | )                    | $          | 0.01 |   | $ | (0.41 | ) | $ | 0.06 |   |

 

Thepro forma amounts reflected above are not representative of the effects onreported net income (loss) in future years because, in general, the optionsgranted typically do not vest for several years and additional awards are madeeach year. The fair value of each option grant is estimated on the grant dateusing the Black-Scholes option-pricing model using the followingweighted-average assumptions:

 
| ** **              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------|------------|------------------------|------------|----------------------|------------|
| ** **              | ** ** | **July 2, 2004**       | ** ** | **June 27, 2003**    | ** ** | **July 2, 2004** | ** ** | **June 27, 2003** | ** ** |
| Dividend yield          |       | 0.0                    | %          | 0.0                  | %          | 0.0 | % | 0.0 | % |
| Expected life (years)   |       | 1.0 - 4.5              |       | 4.5                  |       | 4.5 |   | 4.5 |   |
| Expected volatility     |       | 42.0                   | %          | 60.0                 | %          | 42.0 – 55.0 | % | 60.0 | % |
| Risk-free interest rate |       | 1.23 – 3.54       | %          | 2.38                 | %          | 1.23 – 2.79 | % | 2.38 – 2.69 | % |

 

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Item 2.  Management’s Discussion andAnalysis of Financial Condition and Results of Operations.

 

*THE INFORMATION IN THISITEM 2**“MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION ANDRESULTS OF OPERATIONS”**CONTAINS FORWARD-LOOKING STATEMENTS, INCLUDING, WITHOUT LIMITATION, STATEMENTSRELATING TO OUR FUTURE BUSINESS PROSPECTS AND ECONOMIC CONDITIONS IN GENERAL,STATEMENTS REGARDING OUR ENGINEERING AND DESIGN ACTIVITIES, PRODUCTDEVELOPMENT, AND NEW PRODUCT INTRODUCTIONS, STATEMENTS RELATING TO FUTUREPRODUCT DEMAND AND OUR FUTURE SALES, EARNINGS, GROSS PROFIT, INCOME, ANDEXPENSES, STATEMENTS REGARDING INTERNATIONAL SALES, STATEMENTS REGARDING THEINTEGRATION OF OUR ACQUISTIONS, ACQUISITION ACCOUNTING, ACQUISITION ANDTRANSACTION COSTS AND ADJUSTMENTS, STATEMENTS ABOUT THE RATIO OF SALES AMONGOUR DISTRIBUTION CHANNELS, STATEMENTS REGARDING FUTURE INVENTORY LEVELS, ANDSTATEMENTS ABOUT THE TIMING, IMPLEMENTATION, AND BENEFITS OF OUR NEW ERP SYSTEMAND STATEMENTS RELATING TO ANTICIPATED CAPITAL NEEDS AND USES.*

 

*THESE FORWARD-LOOKINGSTATEMENTS ARE SUBJECT TO CERTAIN RISKS AND UNCERTAINTIES THAT COULD CAUSE OURACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THEFORWARD-LOOKING STATEMENTS.  FACTORS THATMIGHT CAUSE SUCH A DIFFERENCE INCLUDE, BUT ARE NOT LIMITED TO, THE RISKSASSOCIATED WITH GENERAL ECONOMIC CONDITIONS, RISKS ATTRIBUTABLE TO FUTUREPRODUCT DEMAND, SALES, AND EXPENSES, RISKS ASSOCIATED WITH PRODUCT DESIGNEFFORTS, RISKS ASSOCIATED WITH RELIANCE ON A LIMITED NUMBER OF COMPONENTSUPPLIERS AND SINGLE SOURCE COMPONENTS, THE LOSS OF ONE OF OUR OEM CUSTOMERS, AREDUCTION OR FLUCTUATIONS IN SALES OF OUR OEM OR BRANDED PRODUCTS, INTENSECOMPETITION AND NEW PRODUCTS AND TECHNOLOGIES FROM EXISTING AND NEWCOMPETITORS, RISKS RELATED TO PROTECTING OUR INTELLECTUAL PROPERTY RIGHTS,FLUCTUATIONS IN FOREIGN CURRENCIES, RISKS RELATED TO ACQUISITIONS AND THEIRSUBSEQUENT INTEGRATION, AND OTHER RISKS DETAILED IN OUR ANNUAL REPORT ON FORM10-K, WHICH WAS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON MARCH 12,2004.*

 

**Overview**

 

AvocentCorporation was formed as a result of the merger transaction in July 2000between Apex Inc. and Cybex Computer Products Corporation, which was accountedfor as an acquisition of Cybex by Apex. Our acquisitions include Equinox Systems Inc. in January 2001, 2CComputing, Inc. in August 2002, Soronti, Inc. in November 2003, and Crystal LinkTechnologies in January 2004. In April 2004 we closed the acquisition of OSATechnologies, Inc.  OSA is a leadingprovider of embedded manageability firmware and software that meets theIntelligent Platform Management Interface (“IPMI”) specifications.

 

We design,manufacture, sell, and license analog and digital KVM (keyboard, video andmouse) switching systems, serial connectivity devices, extension, wirelessextension, and remote access products, IPMI firmware and software, and relatedtechnologies for the computer industry. Data center managers and networkadministrators have increasingly complex and growing server populations, andour analog, digital, and serial switching solutions, as well as our IPMI,extension and remote access products and technologies, help them managemultiple servers and serially controlled devices from a single local or remoteconsole consisting of a keyboard, video monitor, and mouse.  Specifically, our products can providesignificant cost reductions including lower initial investment, reduced utilitycosts, and space savings, as well as more efficient technical supportcapabilities.

 

We provide“plug and play” switching systems for many network administration, management,and storage problems faced by corporate customers, data centers, and serverfarms. Our switching solutions include products and technologies sold orlicensed under the Avocent, Apex, Cybex, Equinoxbrands, including our *AMX*TM,*AutoViewTM, DS SeriesTM, SwitchView®,OutLook®, LongViewTM,*and*XP®4000Series* products. Our switching systems and solutions help facilitiesmanagers and network administrators access multiple servers and seriallycontrolled devices from one or more centralized or remote consoles, consolidatehardware requirements, and provide direct hardwired connections between theswitch and the attached servers to facilitate access to those servers, evenwhen the network is down. Our Equinox branded products add high-performance,reliable, and affordable server-based products for serial and dial-up accessapplications.  The Equinox *SuperSerialTM* product line provides serial communications forsecurity, commercial point-of-sale, process control, industrial automation,data collection, remote access, fax servers, Internet access, and customapplications. Our Digital Desktops product line includes the *CstationTM* product. Initial applications for Cstation include financial trading floors wherespace is at a premium, industrial plant control environments that benefit fromremote computers due to harsh or unsecured environments, and governmentinstallations that require high security afforded through the remote locationof the computer and hard disk. In late 2003, we introduced *LongView*TM*Wireless,*which allows for wirelesscontrol of monitors, keyboards, mice, and audio devices on a computer up to 100feet away.  We offer our KVM, Equinox,and LongView solutions through external appliances and embedded solutionswithin products sold by others.

 

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Thecombination of OSA’s technology and expertise with our current embedded KVMsolutions builds on our strategy of providing a common management interface toenable automation of the monitoring, configuration, and provisioning of serverroom devices.  We believe these embeddedtechnologies will extend Avocent’s growth opportunities beyond our traditionalKVM products.

 

A substantialportion of our revenue is derived from sales to a limited number of OEMs whopurchase our switching systems on a private-label or branded basis forintegration and sale with their own products, sales through our reseller anddistributor network, and sales to a limited number of direct customers. Salesto our OEM customers accounted for 42% of sales in the first six months of 2004and 46% of sales in the first six months of 2003.  Sales to our branded customers accounted for58% of sales in the first six months of 2004 and 54% of sales in the first sixmonths of 2003. We do not have contracts with many of our OEM and brandedcustomers, and in general, they are obligated to purchase products from us onlypursuant to binding purchase orders.  Theloss of, or material decline in orders from, our OEM or certain brandedcustomers would have a material adverse effect on our business, financialcondition, results of operations, and cash flows.  Our top five customers include both OEM andbranded customers, and accounted for 64% of sales in the first six months of2004 and 56% of sales in the first six months of 2003.

 

We sellproducts to dealers, end-users, and OEMs in the United States, Canada, Europe,and Asia as well as in other foreign markets. Sales within the United States accounted for approximately 60% of salesin the first six months of 2004 and 61% of sales in the first six months of 2003.  Sales outside of the United States accountedfor 40% of sales in the first six months of 2004 and 39% of sales in the firstsix months of 2003.  Sales to customersin the Netherlands, including the European distribution facility for one of ourOEM customers, accounted for 11% of our sales in the first six months of2004.  Sales to customers in the UnitedKingdom, including the European distribution facility for one of our OEMcustomers, accounted for 13% of our sales in the first six months of 2003.  No other country accounted for more than 10%of sales in the first six months of either 2004 or 2003.

 

With continuedindustry-wide initiatives to reduce all channel inventories and to shorten leadtimes, trends with our major customers are, generally, to reduce the number ofweeks of forward-committed firm orders. This trend continues to affect ourbusiness with certain distributors, OEMs, and other server manufacturers,and we believe that it will continue to make our future sales difficult topredict and inventory levels more difficult to manage.

 

We continue to experience significant price competition in the marketfor all of our products, and we expect that pricing pressures will continue inthe future.  In addition, generaleconomic conditions continue to be unpredictable, and we expect our revenuegrowth rate to fluctuate in relation to economic conditions and IT relatedspending trends.  Depending on futuregeneral economic conditions and other factors, our revenue could decline in thefuture.

 

Weimplemented a new enterprise resource planning system in the fourth quarter of2003 at our United States locations, and we implemented the system at ourinternational locations during July 2004. We have capitalized the developmentand implementation costs of the new system to date and have begun depreciatingthe costs for the system used in the United States.  As of July 2, 2004, $10.7 million had beencapitalized for the new system for all our locations.  Approximately $6.9 million had been placed inservice for locations in the United States as of July 2, 2004, and theremaining $3.8 million was placed in service for our locations outside theUnited States during July 2004. We will begin depreciating the capitalizedcosts for the international system in the third quarter of 2004.  We expect the new system to provide manybenefits, including more detailed information to improve the ways we manageinventory, customer relationships, and operating expenses on a more timely basis.

 

Many of our executive officers and directors are vested in significantamounts of options to purchase shares of our common stock and continue to vestin additional shares on a regular basis. These officers and directors have informed us that they have sold, andmay sell additional, shares of our common stock to provide liquidity anddiversify their portfolios.

 

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Results of Operations

 

The following table sets forth, for the periods indicated selectedstatement of operations data expressed as a percentage of net sales:

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                            | ** ** | **July 2, 2004**       | ** ** | **June 27,  2003**   | ** ** | **July 2,  2004** | ** ** | **June 27,  2003** | ** ** |
|                                                  |       |                   |       |                 |       |   |   |   |   |
| Net sales                                             |       | 100.0                  | %          | 100.0                | %          | 100.0 | % | 100.0 | % |
| Cost of sales                                         |       | 42.4                   |       | 42.4                 |       | 42.1 |   | 43.5 |   |
| Gross profit                                          |       | 57.6                   |       | 57.6                 |       | 57.9 |   | 56.6 |   |
| Operating expenses:                                   |       |                   |       |                 |       |   |   |   |   |
| Research and development expenses                     |       | 12.8                   |       | 10.8                 |       | 11.9 |   | 10.1 |   |
| Acquired in-process research and  development expense |       | 24.7                   |       | —               |       | 16.2 |   | — |   |
| Selling, general and administrative  expenses         |       | 25.1                   |       | 25.7                 |       | 24.4 |   | 24.5 |   |
| Amortization of intangible assets                     |       | 7.3                    |       | 8.7                  |       | 6.4 |   | 8.7 |   |
| Total operating expenses                              |       | 69.9                   |       | 45.2                 |       | 58.9 |   | 43.4 |   |
| Income (loss) from operations                         |       | (12.3                  | )          | 12.4                 |       | (1.0 | ) | 13.2 |   |
| Net investment income                                 |       | 1.2                    |       | 1.8                  |       | 1.3 |   | 1.8 |   |
| Net realized investment losses                        |       | (0.1                   | )          | (0.2                 | )          | (0.1 | ) | (0.2 | ) |
| Other expense, net                                    |       | (0.1                   | )          | (0.2                 | )          | (0.1 | ) | (0.3 | ) |
| Income (loss) before income taxes                     |       | (11.3                  | )          | 13.9                 |       | 0.1 |   | 14.5 |   |
| Provision for income taxes                            |       | 3.9                    |       | 3.5                  |       | 2.9 |   | 3.6 |   |
| Net income (loss)                                     |       | (15.2                  | )%         | 10.4                 | %          | (2.8 | )% | 10.9 | % |

 

*Net sales.*  Our net sales consist of sales of keyboard,video, and mouse console switching systems, digital connectivity solutions,serial connectivity devices, wireless extension products, and extension andremote access solutions. Net sales increased 24% to $87.8 million for the secondquarter of 2004 from $70.6 million for the second quarter of 2003.  The increase in sales resulted from thestrength of our U.S. branded sales in the second quarter of 2004 as compared tothe second quarter of 2003. Additionally, branded sales in Asia were almost $2.5 million in thesecond quarter of 2004, the highest quarterly sales that we have recorded todate for this region.  Overall, brandedsales grew 29% from $38.9 million in the second quarter of 2003 to $50.0million in the second quarter of 2004. As a percentage of sales, branded revenue accounted for 57% of sales inthe second quarter of 2004 and 55% of revenue in the second quarter of2003.  An increase in sales from our OEMcustomers in Europe and Asia also contributed to our sales growth.  OEM sales grew 19% from $31.7 million in thesecond quarter of 2003 to $37.8 million in the second quarter of 2004.  OEM sales were 43% of sales for the secondquarter of 2004, compared to 45% of sales for the second quarter of 2003.  Sales of our digital products continued toincrease and represented 47% of our revenue in the second quarter of 2004 ascompared to 36% of our revenue in the second quarter of 2003.  Additionally, sales of our productsintroduced within the last twelve months contributed almost $10.5 million torevenue in the second quarter of 2004. These new products include our AMX, AVR, and the latest SwitchViewproduct introductions.

 

We experiencedan increase in sales both within the United States and internationally. Saleswithin the United States increased 20% to $52.9 million in the second quarterof 2004 from $44.2 million in the second quarter of 2003.  International sales increased 32%, to $34.9million in the second quarter of 2004 from $26.4 million in the second quarterof 2003.  Sales within the United Stateswere 60% of sales for the second quarter of 2004 and 63% of sales for thesecond quarter of 2003.  Internationalsales were 40% of sales for the second quarter of 2004 and 37% of sales for thesecond quarter of 2003.

 

Net salesincreased 23% to $173.9 million for the first six months of 2004 from $141.8million for the first six months of 2003. As with the second quarter, the increase in sales resulted from newproduct introductions and from increased sales of our digital products.  The strength in sales on a year-to-date basiswas evident both in U.S. and international sales.  Sales within the United States increased byapproximately 20% to $104.1 million in the first six months of 2004 from $86.5million in the first six months of 2003. International sales increased approximately 26% to $69.8 million in thefirst six months of 2004 from $55.3 million in the first six months of2003.  Additionally, sales to our brandedcustomers increased 31% to $100.7 million in the first six months of 2004 from$76.9 in the first six months of 2003, while sales to our OEM customersincreased 12% to $73.2 million in the first six months of the 2004 from $64.9in the first six months of 2003.

 

Revenue forthe second quarter of 2004 was at the high end of our guidance, and our outlookfor the remainder of 2004 remains positive. We have seen mixed economic indicators during the past quarter, butbelieve the overall tone of our business remains positive.

 

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Product introductions currently planned for the remainder of the year,combined with expected revenue contributions from our recent acquisitions,should allow us to continue our positive revenue growth trend for 2004.  While certain product families that willgenerate revenue from our embedded products have been delayed at certain of ourcustomers due to delays from another supplier of critical components for thosecustomers, we expect revenue from our embedded products to contribute to salesgrowth in the second half of 2004.  Weexpect revenues to grow between 18% and 22% for 2004 as compared to 2003.  For the third quarter of 2004, we expectrevenue to be in the $89 to $93 million range.

 

*Grossprofit.* Gross profit may be affected by a varietyof factors, including: the ratio of sales among our distribution channels, asOEM sales have lower gross margins than our branded sales; absorption of fixedcosts as sales levels fluctuate; product mix, raw materials, and labor costs;new product introductions by us and by our competitors; and the level of ouroutsourcing of manufacturing and assembly services.  Gross profit remained constant at 57.6% inthe second quarter of 2004 as compared to the second quarter of 2003.  Although gross margins remained constant,there were several offsetting factors that affected our margins in the secondquarter of 2004.  The primary reasonmargins in the second quarter of 2004 remained strong relates to the increasein mix of branded sales as compared to OEM sales, especially in the digital andthe SwitchView product lines. Additionally, our AMX product line grew from 3.4%of sales in the second quarter of 2003 to 6.2% of sales in the second quarterof 2004.   These product lines havehigher than average margins.  Ourengineering and operations teams continue to work to lower product coststhrough product redesign to eliminate costly components and throughnegotiations with our contract manufacturers to reduce costs in our supplychain.  However, we recorded additionalreserves of approximately $900,000 in the second quarter of 2004 to coverestimated exposure related to excess and obsolete inventory.  We continually monitor our reserve balancefor adequacy based on a variety of factors and record adjustments to reservesas needed. Gross margin increased to 57.9% for the first six months of 2004from 56.6% for the first six months of 2003, primarily as a result of thehigher mix of branded sales in the first quarter of 2004 when compared to thefirst quarter of 2003.

 

We expect gross margins to average between 56% and 58% in the remainingquarters of 2004.  However, for the thirdquarter of 2004, we expect a higher mix of OEM sales, with the result that ourmargins may be flat to slightly down compared to the third quarter of 2004. Forthe year, we expect continued cost reductions from engineering redesigns,revenue from our embedded products, which have higher gross margins, and pricereductions from our contract manufacturers to help offset the adverse impactfrom competitive and customer pressures.

 

*Researchand development expenses.*  Research and development expenses includecompensation for engineers, support personnel, outside contracted services andmaterials costs, and are expensed as they are incurred.  Research and development expenses were $11.2million, or 12.8% of net sales, in the second quarter of 2004 compared to $7.7million, or 10.8% of net sales, for the second quarter of 2003.  The increase in the amount spent on researchand development can be attributed to an increase in headcount, primarily as aresult of the Soronti purchase in November 2003, the Crystal Link acquisitionin early 2004, and the OSA acquisition early in the second quarter of2004.  Other factors related to theincrease include adding additional test labs and increasing the amount spentfor materials, certification, and testing of products as we accelerate thespeed and number of our product introductions. We continue to invest heavily in new technologies such as embedded KVM,digital desktop extension, IPMI solutions, and wireless KVM solutions. Researchand development expenses for the first six months of 2004 increased to $20.7million from $14.5 million for the first six months of 2003 for the reasonslisted above.  As a percentage of netsales, year-to-date research and development expenses increased to 11.9% from10.1%.  We believe that the timelydevelopment of innovative products and enhancements to existing products isessential to maintaining our competitive position.

 

In the third quarter of 2004, we expect research and developmentexpense to slightly increase sequentially but be flat as a percentage ofsales.  For the remainder of the year, weexpect research and development expenses to continue to increase as apercentage of sales as we continue to add software content to our products.

 

*Acquiredin-process research and development expense and other acquisition costs.*  Acquisition related expenses in the secondquarter of 2004 are comprised solely of the non-recurring write-off of$21.7 million of in-process research and development expense related tothe acquisition of OSA. Acquisition related expenses in the first six months of2004 also include the non-recurring write-off of $6.5 million ofin-process research and development expense related to the acquisition ofCrystal Link. There were no such charges in the first six months of 2003.

 

***Selling, general and administrative expenses.***  Selling, general and administrative expensesinclude personnel costs for administration, finance, information systems, humanresources, sales and marketing and general management, as well as some mergerand acquisition related expenses, rent, utilities, legal and accountingexpenses, bad debts, advertising, promotional material, trade show expenses andrelated travel costs.  Selling, generaland administrative expenses were $22.0 million, or 25.1% of net sales, for thesecond quarter of 2004 compared to $18.1 million, or 25.7% of net sales, forthe second quarter of 2003.  The increasein selling, general and administrative expenses is primarily related toincreased headcount as a result of the Soronti, Crystal Link, and OSAacquisitions.  We also

 

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continueto expand our international sales infrastructure.  Other factors contributing to higher selling,general and administrative expenses were higher depreciation related to the SAPimplementation, costs of compliance with the Sarbanes-Oxley Act of 2002, andhigher legal fees associated with protecting our intellectual property rights.Year-to-date selling, general, and administrative expenses increased to $42.4million, or 24.4% of net sales for 2004, from $34.8 million, or 24.5% ofyear-to-date net sales in 2003, as a result of the factors mentioned above.

** **

**Weexpect our selling, general and administrative expenses to be relatively flatin the third quarter of 2004 when compared sequentially to the second quarterof 2004.  We expect patent litigationexpense and Sarbanes-Oxley compliance and audit costs to increase slightly, inthe third and fourth quarters of 2004. We expect these increases to bepartially offset by lower trade show and insurance costs.**

 

***Amortization of intangible assets***. Amortization of $6.4 million in the second quarter of 2004 is comprisedof the amortization of the identifiable intangible assets created as a resultof the merger transaction between Apex and Cybex and the acquisitions ofEquinox, 2C, Soronti, Crystal Link, and OSA. Amortization of $6.2 million in 2003 is comprised of the amortization ofthe identifiable intangible assets created as a result of the mergertransaction between Apex and Cybex and the acquisitions of Equinox and 2C.  The slight increase in amortization expenserelates primarily to the additional amortization of intangibles from theSoronti, Crystal Link, and OSA acquisitions, which were offset by completingamortization during 2003 of several significant intangible assets recorded onthe merger of Apex and Cybex and the acquisition of Equinox. Amortization expensedecreased slightly from $12.3 million in the first six months of 2003 to $11.2million in the first six months of 2004 as a result of the factors mentionedabove.  Amortization expense in the thirdand fourth quarters of 2004 is expected to remain flat when compared to theamount from the second quarter of 2004.

 

*Net investment income**.********** *Net******investmentincome decreased slightly to $1.0 million in the second quarter of 2004 from$1.3 million the second quarter of 2003. Although we had more cash and investments in 2004 than in 2003, theincrease in available funds did not offset the decline in continued lowerinterest rates**. **Inaddition, in order to have funds available for the OSA acquisition, wemaintained a higher level of liquid investments, which yielded a lower rate ofreturn. Net investment income decreased from $2.5 million in the first sixmonths of 2003 to $2.3 million in the first six months of 2004 as a result ofthe factors mentioned above.

 

*Netrealized investment losses. *Netrealized investment losses improved slightly from $123,000 in the secondquarter of 2003 to $104,000 in second quarter of 2004.  Net realized investment losses improvedslightly for the first half of the year as well, from $210,000 in the first sixmonths of 2003 to $168,000 in the first six months of 2004.

 

*Other expense, net.*  Net other expense improved slightly from anexpense of $114,000 in the second quarter of 2003, to an expense of $98,000 inthe second quarter of 2004. For the first half of the year, net other expenseimproved from an expense of $419,000 in the first six months of 2003 to anexpense of $148,000 in the first six months of 2004. The improvement relatedprimarily to foreign exchange losses of $294,000 recorded in the first quarterof 2003 as compared to approximately $29,000 recorded in the first quarter of2004.

 

*Provisionfor income taxes.*  Theprovision for income taxes was approximately $5.1 million for the six monthsended July 2, 2004, compared to $5.1 million for the six months ended June 27,2003.  The increase in the effective tax rate is primarily attributable tothe impact of $21.7 million of acquired in-process research and developmentexpense, which is not deductible for tax purposes, and $1.4 million ofadditional deferred compensation expense (related to assumed incentive stockoptions which have no tax benefit to the company)  recorded during the second quarter as aresult of the acquisition of OSA.   This amount was offset by the taximpact of a higher mix of pre-tax income contributed by our Shannon operationsthat is taxed at a lower rate. Including these items, we expect our effective tax rate to be in the40% to 42% range for the year ended December 31, 2004.

 

*Net income(loss).* Net loss for the second quarter of 2004 was $13.4 million compared tonet income of $7.3 million for the second quarter of 2003, as a result of theabove factors, including increases in selling, general and administrativecharges, research and development expenses and the write-off of acquiredresearch and development expense as a result of the OSA acquisition, offsetsomewhat by the increase in our revenues. As a percentage of sales, net loss for the second quarter of 2004 was15.2%, compared to net income of 10.4% for the second quarter of 2003. For the firsthalf of the year, the net loss was $4.9 million, or 2.8%, in 2004 as comparedto net income of $15.5 million, or 10.9% of net sales, in 2003 as a result ofthe factors mentioned above.

 

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**Liquidity and Capital Resources**

 

As of July 2,2004, our principal sources of liquidity consisted of over $289 million incash, cash equivalents, and investments. We have no outstanding debt or available credit facilities as of thisfiling.

 

Our operatingactivities generated cash of over $32.5 million in the first six months of2004, compared to approximately $38.7 million in the six months of 2003.  The reduction in positive cash flow is theresult of increases in both inventories and accounts receivable.  Inventories increased from $21.3 million atDecember 31, 2003 to $22.0 million at July 2, 2004.  The increase in inventory was primarily theresult of adding inventory in anticipation of new product introductions plannedin the second half of 2004.  Ourinventory turns for the latest quarter were 6.7, slightly below our goal of 7.We will continue to monitor our inventory closely as we have over the lastseveral years and work to increase our turns.  We experienced an increase in receivables as a result of the timing andvolume of sales in the second quarter of 2004. Additionally, our DSOs increased slightly to 50 days from 49 days forthe same period last year.  The DSOs arebetter than our goal of 60 days.  Adecline in accounts payable and in accrued compensation also affected cash flowfrom operations for the first six months of 2004.

 

Weimplemented a new enterprise resource planning system in the fourth quarter of2003 at our United States locations, and in our international locations, exceptfor OSA, during July 2004. We have capitalized the costs of the new system todate and have begun depreciating the costs for the portion of the system usedin the United States.  As of July 2,2004, $10.7 million had been capitalized for this new system and $6.9 million hadbeen placed in service for our locations in the United States. We expect thetotal cost of the new system to be $12.0 to $13.5 million.

 

In the ordinary course of our business, we may at any point in timehave a significant amount of contractual commitments not yet recognized in ourfinancial statements. These commitments relate primarily to our need toschedule the purchase of inventories in advance of the related forecasted salesto customers. We have longer lead times for the products we purchase fromsuppliers based in Asia than those for our U.S. based and European suppliers.Our actual contractual commitments are typically limited to products needed forone to three months of forecasted sales. The liabilities for these inventorypurchases along with the related inventory assets are typically recognized uponour receipt of the products. We also have at any point in time a variety ofshort term contractual commitments for services such as advertising, marketing,accounting, legal, and research and development activities. The liabilities forthese services and the related expenses are typically recognized upon ourreceipt of the related services.  As ofJuly 2, 2004, we had $20.7 million of such commitments.  None of our expected purchase commitments requiredpayment beyond the next year.

 

We intend touse a portion of our cash and investments for strategic acquisitions oftechnologies and companies that will enhance and complement our existingtechnologies and help increase our sales.

 

**Investments**

 

Our investmentsconsist primarily of bank deposits, money market funds, corporate bonds,municipal bonds, commercial paper, mortgage backed securities guaranteed byU.S. government agencies, and common stock. We classify our debt and equitysecurities as available-for-sale securities and report them at fair value, withunrealized gains and losses excluded from earnings and reported as a separatecomponent of stockholders’ equity. We periodically review our investmentportfolio for investments considered to have sustained another-than-temporary decline in value.  Upon review of our investment portfolio as of July 2, 2004, noinvestments were considered to have sustained an other-than-temporarydecline, and no impairment charge was recorded.

 

**Certain Transactions**

 

***Acquisition of Crystal LinkTechnologies***

 

On January 6, 2004, we acquired Crystal Link Technologies for aninitial payment of cash and common stock of approximately $6.7 million, plusassumed liabilities of approximately $2.1 million and acquisition costs ofapproximately $163,000. The purchase agreement calls for possible additionalearn-out payments of up to $5.0 million based on future technical enhancementsand sales goals.  Crystal Link, based inEscondido, California, has developed wireless technology for KVM switching andextension products, which is incorporated into our LongView Wireless product.

 

We recorded the acquisition under the purchase method of accounting,and allocated the purchase price based on the fair value of the assets acquiredand liabilities assumed. In accordance with generally accepted accountingprinciples, purchased research and development costs allocated topatent-pending technology were capitalized and will be amortized over therespective estimated useful

 

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lives.  The remaining amounts of purchased researchand development were expensed upon the closing of the transaction.  The valuation resulted in an excess ofacquired nets assets over cost, or negative goodwill of approximately $143,000.As prescribed under FAS 141, *Business Combinations*,the negative goodwill was recorded as a contingent liability due to thepotential future earn-outs.  Goodwillwill likely be recorded if the additional earn-outs mentioned previously areachieved.  If the earn-outs are notachieved, the negative goodwill will be allocated across all acquired assets,including acquired research and development expense.  In the event goodwill is recorded due to theearn-out payments, then goodwill will not be amortized but will be included inour annual review of goodwill for impairment.

 

***Acquisitionof OSA Technologies, Inc.***

 

On April 6, 2004, we acquired OSA Technologies, Inc. (OSA) for cash andcommon stock of $97.5 million, plus assumed liabilities of approximately $1.7million, employee stock options of approximately $2.5 million and acquisitioncosts of approximately $1.1 million. Additionally, we recorded $6.4 million of deferred compensation relatedto the OSA employee stock options at the time of the acquisition on April 6,2004.  OSA is headquartered in San Jose,California and has additional offices in Shanghai, China and Taipei, Taiwan.OSA has developed embedded manageability firmware and software using IntelligentPlatform Management Interface (IPMI) solutions. The results of OSA’s operationshave been included in the consolidated financial statements since the date ofacquisition.

 

Theacquisition was recorded under the purchase method of accounting, and thepurchase price was allocated based on the fair value of the assets acquired andliabilities assumed. In accordance with generally accepted accountingprinciples, purchased research and development costs allocated topatent-pending technology were capitalized and will be amortized over the respectiveestimated useful lives.  The remainingamounts of purchased research and development were expensed upon the closing ofthe transaction.  The goodwill recordedas result of the acquisition will not be amortized but will be included in ourannual review of goodwill for impairment. The excess of the fair value over theintrinsic value of the unvested OSA options and the fair value of the vestedOSA options at the date of consummation have been included in the purchaseconsideration.

 

**CriticalAccounting Policies**

 

We believe thefollowing critical accounting policies affect the more significant judgmentsand estimates used in the preparation of our consolidated financial statements:

 

•                                          Wereview customer contracts to determine if all of the requirements for revenuerecognition have been met prior to recording revenues from salestransactions.  We generally record salesrevenue upon shipment of our products, net of any discounts, since we generallydo not have significant post delivery obligations, the product price is fixedand determinable, collection of the resulting receivable is probable, andproduct returns are reasonably estimable. We generally ship products upon receipt of a purchase order from acustomer.  We record revenue inaccordance with the applicable terms of each respective customer contract.  Accordingly, revenue on products shipped FOBdestination is recorded when the customer takes possession of the goods, andrevenue on products shipped FOB shipping point is recorded when the goods leaveour facilities.  Shipping and handlingfees are included in net sales, and the related costs are included in cost ofsales in the accompanying consolidated statements of operations.

 

We accrue forsales returns as a reduction of sales and cost of sales based on our experiencefrom historical customer returns, which we believe provides a reasonableestimate of future returns.  Our salesagreements generally include a one-month unconditional return policy.  We also allow additional rights of return tocertain distributors, which generally extend the return period to 90 days.  If actual future customer returns are lessfavorable than those projected by management, additional sales return costs maybe incurred.    The reserve is includedas a reduction in the carrying value of accounts receivable in the accompanyingconsolidated balance sheets.

 

We recordroyalty revenue upon shipment by OEMs of the related products within which ourtechnologies are embedded or upon release of our software which welicense.  Revenue from our maintenanceand support agreements is deferred and recognized ratably over the term of theagreements.

 

Prior toextending credit to a new customer, we perform a detailed credit review of thecustomer and establish credit limits based on the results of our creditreview.  We review collection experienceperiodically to determine if the customer’s payment terms and credit limitsneed to be revised.  We maintain allowancesfor doubtful accounts for estimated losses resulting from the inability of ourcustomers to make required payments.  Ifthe financial condition

 

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of ourcustomers were to deteriorate, resulting in an impairment of their ability tomake payments, additional allowances may be required.  If circumstances change with regard toindividual receivable balances that had previously been determined to beuncollectible (and for which a specific reserve had been established), areduction in our allowance for doubtful accounts may be required.

 

Weparticipate in cooperative advertising and market development programs withcertain distributors and OEMs. We use these programs to reimburse distributorsand OEMs for certain forms of advertising, and in general, allow distributorsand OEMs credits up to a specified percentage of net purchases. Our costsassociated with these programs are estimated and accrued at the time of sale,and are included in sales and marketing expenses in the accompanyingconsolidated statements of operations. Payments of invoices submitted by our customers are deducted from theaccrued liability.

 

•                                          Wecarry our inventory at the lower of cost or market, with cost being determinedusing the first-in, first-out method.  Weuse standard costs for material, labor, and manufacturing overhead to value ourinventory.  We review and revise ourstandard costs on a quarterly basis. Therefore, our inventory costs approximate actual costs at the end of eachreporting period.  We write down our inventory forestimated obsolescence or unmarketable inventory to the estimated market valuebased upon assumptions about future demand and market conditions.  If actual future demand or market conditionsare less favorable than those projected by management, additional inventorywrite-downs may be required.

 

•                                          Weprovide for the estimated cost of product warranties at the time revenue isrecognized.  While we engage in extensiveproduct quality programs and processes, including actively monitoring andevaluating the quality of our component suppliers and contract manufacturers,our warranty obligation is affected by product failure rates, failure rates ofpurchased components integrated into our products, material usage, and otherrework costs incurred in correcting a product failure.  Should actual product failure rates, materialusage, or other rework costs differ from our estimates, revisions to ourestimated warranty liability may be required.

 

•                                          Wehold investments in various publicly traded debt securities, includingmortgaged-backed and other asset-backed securities.  We record an investment impairment chargewhen we believe an investment has experienced a decline in value that is otherthan temporary.  Future adverse changesin market conditions or poor operating results of underlying investments couldresult in losses or an inability to recover the carrying value of theinvestments that may not be reflected in an investments current carrying value,thereby possibly requiring an impairment charge in the future.  There were noother-than-temporary impairment charges recorded against investments in 2004 or2003.

 

We also investin privately held entities and generally record our investments in theseentities at cost or we use the equity method if we have the ability to exercisesignificant influence over the entity. We review our investments in these entities periodically to determine ifcircumstances (both financial and non-financial) exist that indicate that wewill not recover our initial investment. We record impairment charges on investments having a carrying value thatis greater than the value that we would reasonably expect to receive in anarm’s length sale of the investment. There were no impairment charges recordedagainst privately-held investments in 2004 or 2003.

 

**•**                                          Effective January 1, 2002, we adopted SFAS No. 142, *Goodwill andOther Intangible Assets,*and ceased amortizing goodwill.  Our initial test for goodwill impairment asof January 1, 2002 determined that no adjustment for impairment wasrequired.  Additionally, our annual testfor goodwill impairment, performed in the fourth quarter of 2003, determinedthat no adjustment for impairment was required. Our testing indicated that the implied fair value of our goodwillexceeded its carrying value; accordingly, in accordance with SFAS 142, nofurther impairment analysis was required. If economic conditions deteriorate and indicators of impairment becomepresent, an adjustment to the carrying value of goodwill and other intangibleassets may be required.

 

**•****                                         **We reviewlong-lived assets for impairment under the guidance prescribed by SFAS No. 144,*Accounting for the Impairment or Disposal ofLong-Lived Assets*. We recognize impairment losses on long-livedassets used in operations when indicators of impairment are present and theundiscounted cash flows estimated to be generated by those assets are less thanthe assets’ carrying values. An impairment loss would be recognized in theamount by which the recorded value of the asset exceeds the fair value of theasset, measured by the quoted market price of an asset or an estimate based onthe best information available in the circumstances.  There were no such losses recognized during2004 or 2003.

 

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**•****                                         **We accountfor income taxes using the asset and liability method. We provide for incometaxes currently payable and, in addition, provide deferred income taxes fortemporary differences between the tax bases of assets and liabilities and theirreported amounts in the financial statements and for known contingencies.Temporary differences relate principally to the allowance for doubtfulaccounts, allowance for sales returns, liability for warranty claims,unrealized gain (loss) on investments, acquired intangible assets, accumulateddepreciation, loss on write-down of investments, and inventory reserves.Valuation allowances are established when necessary to reduce deferred taxassets to the amount expected to be realized.

 

Weundergo various tax authority audits in the ordinary course of business andreserve for known tax contingencies as they arise.  If tax audit adjustments differ from theamounts we have provided, we record differences as changes in estimates in theperiod in which they become known.

 

**Item 3.****Quantitative and QualitativeDisclosures About Market Risks.**

 

Our primarymarket risk is the potential loss arising from increases in interest rates,which could have an adverse impact on the fair value of our investmentsecurities. Our investment policy is to manage our investment portfolio topreserve principal and liquidity while maximizing the return on our investmentportfolio through the investment of available funds. We diversify ourinvestment portfolio by investing in a variety of highly-rated investment-gradesecurities and through the use of different investment managers. Our investmentsecurities portfolio is primarily invested in securities with maturities (orinterest rate resets) of two years or less with at least an investment graderating to minimize interest rate and credit risk as well as to provide for animmediate source of funds. Market risk, calculated as the potential change infair value in our investment portfolio resulting from a hypothetical 10% changein interest rates, was not material at July 2, 2004. We generally holdinvestment securities until maturity.

 

We also faceforeign currency exchange rate risk to the extent that the value of certainforeign currencies relative to the U.S. dollar affects our financialresults.  Our international operationstransact a portion of our business in currencies other than the U.S. dollar,predominantly the euro, and changes in exchange rates may positively ornegatively affect our revenues, gross margins, operating expenses, and retainedearnings since these transactions are reported by us in U.S. dollars.  We occasionally purchase foreign currencyforwards aimed at limiting the impact of currency fluctuations.  These instruments provide only limitedprotection against currency exchange risks, and there can be no assurance thatsuch an approach will be successful, especially if a significant and suddendecline occurs in the value of local currencies. As of July 2, 2004, we had noopen forward contracts.

 

**Item 4.****Controls and Procedures.**

 

(a) *Evaluation of disclosure controlsand procedures.*    Based ontheir evaluation as of July 2, 2004, our Chief Executive Officer and ChiefFinancial Officer have concluded that our disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Actof 1934) are effective to ensure that information required to be disclosed byus in reports that we file or submit under the Exchange Act is recorded,processed, summarized and reported within the time periods specified inSecurities and Exchange Commission rules and forms.

 

(b) *Changes in internal control overfinancial reporting*.    Therewere no significant changes in our internal control over financial reporting orin other factors that could significantly affect these controls subsequent tothe date of their evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses. We are in the process ofimplementing a new ERP system, which we expect, when fully implemented, willenhance our internal control over financial reporting through the automationand standardization of certain controls and processes and will support ouranticipated future growth.  We havereviewed the internal controls over financial reporting in place at OSA andexpect to implement limited changes to align those with our internal controlsat other locations.

 

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**PARTII — OTHER INFORMATION**

 

**Item 1.****           Legal Proceedings.**

 

In May 2001, we filed acomplaint for patent infringement in the United States District Court for theSouthern District of New York against Raritan Computer Inc. The Raritancomplaint sought injunctive relief, damages, attorneys’ fees and costs underthree of our patents.  After a seven daybench trial in New York in January of 2002, U.S. District Judge MiltonPollack found that there was no infringement of these patents by Raritan andordered that judgment be entered in favor of Raritan.

 

In April 2003,the United States Court of Appeals for the Federal Circuit issued its ruling onour appeal in this patent litigation. The Court of Appeals ruled in our favor by vacating the non-infringementdecision of the District Court for the Southern District of New York andremanding the case for further proceedings consistent with the Court ofAppeals’ opinion.

 

In September 2003, Raritan petitioned the United States Supreme Courtfor a Writ of Certiorari to review the Court of Appeals decision.  The Supreme Court declined to reviewRaritan’s petition in December 2003, and the case is now back before the UnitedStates District Court for the Southern District of New York.

 

In October 2003, we filed a complaint for patent infringement in theUnited States District Court for the Northern District of Alabama againstClearCube Technology, Inc.  The ClearCubecomplaint seeks injunctive relief, damages, attorneys’ fees, and costs undertwo of our patents. ClearCube filed counterclaims alleging non-infringement,unenforceability, invalidity, and misuse of the Avocent patents.

 

**Item 2.****           Changesin Securities, Use of Proceeds and Issuer Purchases ofEquity Securities.**

 

On January 6,2004, we issued an aggregate of 106,838 shares of our common stock to theshareholders of Crystal Link in connection with our acquisition of CrystalLink.  On April 6, 2004, we issued anaggregate of 1,229,057 shares of our common stock to the shareholders of OSA inconnection with our acquisition of OSA. These sales of securities were exempt from registration under theSecurities Act of 1933, as amended, pursuant to Regulation S or Rule 506 ofRegulation D.  The resale of these shares was filed on a registrationstatement on Form S-3 with the Securities and Exchange Commission which becameeffective in July 2004.

 

**Item 4.****           Submissionof Matters to a Vote of Security Holders.**

 

On June 10, 2004, we held our Annual Meetingof Stockholders.  The matters voted on atthe meeting and the results of these votes are as follows:

 

1. Election of Class II Directors.

 
| ** **            | ** ** | **Votes for** | ** ** | **Votes Withheld** | ** ** |
|-----------------------|------------|---------------|------------|--------------------|------------|
| 1. William H. McAleer |       | 39,754,861    |       | 4,857,192          |       |
| 2. David P. Vieau     |       | 40,197,530    |       | 4,414,523          |       |
| 3. Doyle C. Weeks     |       | 40,878,726    |       | 3,733,327          |       |

 

2. Ratification of the appointment of PricewaterhouseCoopers LLP as ourindependent auditors for the fiscal year ending December 31, 2004.

 
| **Votes For** | ** ** | **Votes Against** | ** ** | **Votes Abstained** | ** ** |
|---------------|------------|-------------------|------------|---------------------|------------|
| 43,001,766    |       | 1,603,475         |       | 6,812               |       |

 

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Item 6.             Exhibitsand Reports on Form 8-K.

 

(a) Exhibits

 

**31.1**                           Sarbanes-OxleyAct of 2002 Section 302(a) Certification of the Chief Executive Officer

 

**31.2**                           Sarbanes-OxleyAct of 2002 Section 302(a) Certification of the Chief Financial Officer

 

32.1                           Certificationof the Chief Executive Officer and the Chief Financial Officer pursuant to 18U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-OxleyAct of 2002.

 

(b) Reports on Form 8-K

 

On April 8,2004, we filed a Report on Form 8-Kwith the SEC regarding the public dissemination of a press releaseannouncing that Avocent had completed the acquisition of OSA Technologies Inc.

 

On April 22, 2004, we filed a Report on Form 8-K with the SEC regarding the publicdissemination of a press release announcing the financial results forour first quarter ended April 2, 2004.

 

ITEMS 3 AND 5 ARE NOTAPPLICABLE AND HAVE BEEN OMITTED.

 

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### **SIGNATURES**

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|   |             | AVOCENT  CORPORATION                                 |   |
|--------|------------------|------------------------------------------------------|--------|
|   |             | (Registrant)                                         |
|   |             |                                                 |
|   |             |                                                 |
| Date:  | August 11,  2004 | /s/ Douglas  E. Pritchett                            |   |
|   |             | Douglas E.  Pritchett                                |
|   |             | Senior Vice  President of Finance, Chief Financial   |
|   |             | Officer and  Treasurer (Principal Financial Officer) |

 

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